Thursday, October 14, 2010

Ricardian equivalence is nonsense.

At least there is a way in which Ricardian equivalence is applied to the stimulus debate which is nonsense, and as follows.

If government borrows and spends in a recession, so the Ricardian argument goes, it will have to raise taxes and pay back the money sooner or later. Plus households are allegedly aware of this. So given a deficit, households will allegedly start saving now for the above future tax hike. And this in turn renders stimulus ineffective. The flaws in this argument are thus.

First, the idea that the average household has enough knowledge about economics to be able to calculate the “deficit per household” is an idea that comes from “la-la” land, as Bill Mitchell put it in his recent blog post about Ricardian equivalence.

However, let’s proceed on the basis that the average household CAN make the above calculation, and proceed to “flaw No. 2”, which is thus.

Government will not necessarily get the money for the payback from increased tax. It may get the money from public spending cuts. Indeed, govt probably WILL do this, to a greater or lesser extent.

And there is no need for households to “save up” for public spending cuts. When the cuts arrive, govt just spends a bit less on roads, the armed forces, the police and so on, and that’s that.

Third, and assuming the pay back comes from tax increases, there is no point in govt paying back the above debt till the economy looks like overheating. I.e. the debt is paid back in a scenario where households cannot effectively spend any more (on pain of causing inflation). Thus taxes have to rise. However there is no point in “saving up” to pay this extra tax in as far as govt grabs this extra tax before the average household gets its hands on the money.

For example most income tax (i.e. for wage earners) is deducted before wage earners see the money (at least that’s the case in Britain and most Western countries). In that govt grabs extra tax before households get their hands on the relevant money, any household which “saves” to meet the tax liability is engaged in double counting.

Turning now to where households DO get their hands on income before govt confiscates a proportion in the form of tax, there is a paradox or self contradiction in household behaviour here, if the average household “saves up” to meet the alleged future tax liability. The paradox is thus.

As pointed out above, a rational govt will only raise taxes where the economy looks like overheating, that is, where households are attempting to spend too much, i.e. and demand goods and services in such a volume that the economy cannot meet the demand.

Now what is the central objective in “saving so as to meet a future tax liability”? The objective is presumably to be able to meet the liability while leaving the household bank balance undiminished. But the whole cause of the problem (excess demand) is caused by households attempting to RUN DOWN their bank balances too fast (or “dissave”).

Let’s summarise that. If the average household is thrifty and saves to meet some future tax liability, demand will not become excessive, so there’ll be no need for the tax! Alternatively, if the average household becomes too spendthrift, demand will rise too far, thus govt will have to increase taxes so as to damp demand. But in this situation, the average household is clearly not aiming to “leave its bank balance undiminished”!

There is a fourth and less important flaw in the Ricardo argument. This is worth a mention because the mere fact that you never see it mentioned by advocates of the argument illustrates their ignorance. The flaw is thus.

If the monetary base and national debt are to remain constant as a proportion of GDP, they will have to be constantly topped up because they are constantly declining in real terms because of inflation. To illustrate, if nat debt and mon base are say 50% of GDP and inflation is 2%, you need a constant and never ending deficit of 2 x 0.5 = 1% of GDP. That portion of the deficit is NEVER paid back. I.e. it is not “future tax”. To illustrate, the U.S. mon base increased from around $50bn in 1960 to around $2,000bn in 2010. (And you can just imagine the average household being fully conversant with that point, can’t you!)

To reiterate, I’ve never seen advocates of the Ricardo argument mention the point in the above paragraph. That is they never say something like “households will save to meet the cost of deficits, except in as far as there is there is need for a constant and never ending deficit of about 1% of GDP per year”.

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Finally, it is always possible that the above mentioned situation where debt has to be paid back to stop the economy overheating may take several years to materialise, during which time a somewhat bloated national debt persists. This may strike some readers as unsatisfactory and I quite agree. That is, I think Keynesian “borrow and spend” has serious flaws. I much prefer what might be called “Modern Monetary Theory / Abba Lerner print and spend”. I’ve set out the reasons here: